Petrocapita February 2012 Briefing - Spare a Moment for the Real Economy


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“According to the Mercer Pension Health Index, the decline in longterm interest rates over the past six months has brought the funded status of Canadian pension funds near the all-time low reached in 2008 (Chart 20). This index declined from 71 per cent in the second quarter of 2011 to 64 per cent at the end of October, indicating that a representative pension plan faces a higher risk of being unable to fully meet its financial obligations.”

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Petrocapita February 2012 Briefing - Spare a Moment for the Real Economy

  1. 1. Petrocapita UpdateFebruary 2012
  2. 2. Petrocapita UpdateCan you spare a moment for the real economy? Despite theundoubted, but cheap, appeal of adding to the chatter aboutwhich country is thought to be going bankrupt this week or whichgovernment believes it can prevent this outcome by the expedientof effectively adding zeroes to amount of its currency in circulation,I thought instead I would try to conduct some analysis of a fewtrends in the productive economy. Sadly, trying to forecast the next12 months, or even the next month for that matter, in large part hasbecome a game of guessing how the markets are going to reactto political announcements in the land of sovereign debt. How, aspeople attempting to make rational economic decisions, can wepossibly predict the day-to-day actions of markets dominated bynon-profit maximizing government and central bankers?It follows that this may be one of those times when long-termtrends are easier to discern than short-term and so today’sdiscussion revolves around some long-term issues in the areas ofpensions and energy. I also want to examine another importanttrend in water resources which I will do in my next briefing.Pensions (see also Agcapita briefings - Pension Funds andHobson’s Choice & Demographics are Destiny): Pension plans areheading into a challenging period for their ability to pay promisedbenefits and perhaps for some even for their solvency. At itscore, the issue arises because a significant number of pensionsassume annual returns in the range of 8% when they are planninghow to meet their obligations - at the same time as they are beingfaced with the Zero Interest Rate Policies (“ZIRP”) and boomerdemographics. As Ron Chernow points out people are beginningto worry that this might not be a workable investment model “Thereis a kind of fear, approaching a panic, that’s spreading through theBaby Boom Generation, which has suddenly discovered that it willhave to provide for its own retirement.”Demographics: It is no secret that the developed world is facinga wave of retirements as boomers move to the end of theirproductive careers. Just how big is this transition? In 2000, theratio of Americans between 15 and 59 years old to those over 1
  3. 3. Petrocapita Update (continued)60 was four to one, according to a United Nations additional capital in the form of higher contributionsreport. In 2050, the ratio will be only two to one. will have to be collected. A recent report from theThe boomers will need to liquidate assets to fund Bank of Canada supports this conclusion. Accordingretirement. However, we can’t all cash out at once to the BOC December 2011 Financial System- pensions are already facing solvency issues and Review “The aggregate solvency of defined-benefitwhen the boomers start to liquidate this issue will pension funds in Canada is close to an all-time low”grow in magnitude with poor equity returns as the (emphasis mine) and further that “According to thetransmission mechanism. If you don’t believe me, Mercer Pension Health Index, the decline in long-here is the bad news straight from the horse’s mouth term interest rates over the past six months has- the US Federal Reserve - an organization which brought the funded status of Canadian pension fundsis much more likely to err on the side of optimism near the all-time low reached in 2008 (Chart 20).than full disclosure: “Historical data indicate a strong This index declined from 71 per cent in the secondrelationship between the age distribution of the U.S. quarter of 2011 to 64 per cent at the end of October,population and stock market performance. A key indicating that a representative pension plan faces ademographic trend is the aging of the baby boom higher risk of being unable to fully meet its financialgeneration. As they reach retirement age, they are obligations.” No mention of course that it is exactlylikely to shift from buying stocks to selling their equity the ZIRP policies followed by the BOC that in part areholdings to finance retirement. .... P/E* should decline responsible for this problem.persistently from about 15 in 2010 to about 8.4 in2025, before recovering to 9.14 in 2030... Moreover, EROEI (see also Agcapita briefing - Start Thinkingthe demographic changes related to the retirement About EROEI): I have touched on the matter of EROEIof the baby boom generation are well known. This on and off over the last year. Put simply, it requiressuggests that market participants may anticipate energy to produce energy and the relationship is asthat equities will perform poorly in the future, an Energy Return On Energy Invested. I’d like to take aexpectation that can potentially depress current short-cut and quote from my 2011 EROEI briefing:stock prices. In that sense, these demographic shiftsmay present headwinds today for the stock market’s Why is EROEI important? Because we are in therecovery from the financial crisis.” Poor equity returns process of transitioning from high EROEI hydrocarbonindeed! sources of energy to low EROEI sources - think Saudi Arabia versus the oil sands. Even if you don’t believeZIRP: How does ZIRP also affect my pension you that peak oil is an immediate issue, I would arguemay ask? A large portion of pension portfolios that EROEI decay is most certainly. Discoveries ofare in fixed income securities that are now yielding conventional oil total roughly 2 trillion barrels, of whicha fraction of the returns required to maintain plan 1 trillion have been extracted so far, with anotherbenefits. The longer ZIRP continues the worse the trillion barrels to go. However the first trillion barrelsproblem will become. Ultimately, the combination of was the oil found on shore or near to shore; closedemographics and ZIRP is going to mean benefits to the surface and concentrated in large reservoirs;will have to be reduced and/or large amounts of in politically stable regions - the “easy oil”. The 2
  4. 4. Petrocapita Update (continued)remaining oil is far offshore or deep underground; to lower EROEI sources of energy - it seems logicalsmaller, harder-to-find reservoirs; in politically unstable that production has to increase faster and faster tolocations- the “difficult” oil. generate the same rate of economic growth.I believe an increasingly reliance on “difficult oil” has Water: An examination of water resources as theysome serious consequences for the global economy. relate to agricultural and industrial output and someThe first is that deliverability - the amount produced practical consequences of water constraints forper year for a given quantity of reserves - will fall, emerging economies - particularly China and India -making it harder to increase total production even if will be included in part 2 of this briefing. In the interimreserves remain relatively abundant. The second is I will leave you with some quick agricultural facts youthat the real cost of extracting the remaining reserves may find interesting:will escalate in terms of the energy inputs required. – In the United States, approximately 3,000 acres of farmland are taken out of productionCurrent production is around 86 million BOPD. every day and used for non-agriculturalHowever an 86 million BOPD oil production profile purposes.of high EROEI sources is very different from 86 – In the United States, 44% of all farmlandmillion BOPD of low EROEI sources. Effectively the is owned by individuals who do not farmnet energy left over to drive economic growth is the land themselves - they lease it back tosignificantly lower in the latter scenario. Here are farmers. In Canada this percent is significantlysome very approximate EROEI ratios for various lower as financial investors are still relativelyenergy sources: new to the market. – 1970s oil & gas discoveries - 30 to 1 – Saskatchewan has approximately 40% – Current conventional oil & gas discoveries - of Canada’s farmland - Alberta and 20 to 1 Saskatchewan together have approximately – Oil Sands - 5 to 1 70% making the two provinces the – Nuclear - 5 to 1 cornerstone of Canadian agriculture. – Photovoltaics - 3 to 1 – China, with 20% of the world population, has – Biofuels - 2 to 1 only 7% of the world’s arable land. – China has lost 20 million acres over the lastAssuming 86 million BOPD composed of 1970s oil 10 years, much of this due to construction& gas - there is around 83 million BOPD net to fuel – Wheat demand is projected to increase togrowth. Assuming 10% 1970s oil & gas, 45% current 775 million tons by 2020 with 2/3 of thisoil & gas and 45% oil sands then this drops to 76 increase coming from emerging economiesmillion BOPD - an 8% reduction. So as we transition that will double their imports. 3
  5. 5. DISCLAIMER: The information, opinions, estimates, projections and other materials contained herein are provided as of the date hereof and are subject to change without notice. Some of the information, opinions, estimates, projections and other materials contained herein have been obtained from numerous sources and Petrocapita Income Trust (“PETROCAPITA”) and its affiliates make every effort to ensure that the contents hereof have been compiled or derived from sources believed to be reliable and to contain information and opinions which are accurate and complete. However, neither PETROCAPITA nor its affiliates have independently verified or make any representation or warranty, express or implied, in respect thereof, take no responsibility for any errors and omissions which maybe contained herein or accept any liability whatsoever for any loss arising from any use of or reliance on the information, opinions, estimates, projections and other materials contained herein whether relied upon by the recipient or user or any other third party (including, without limitation, any customer of the recipient or user). Information may be available to PETROCAPITA and/or its affiliates that is not reflected herein. The information, opinions, estimates, projections and other materials contained herein are not to be construed as an offer to sell, a solicitation for or an offer to buy, any products or services referenced herein (including, without limitation, any commodities, securities or other financial instruments), nor shall such information, opinions, estimates, projections and other materials be considered as investment advice or as a recommendation to enter into any transaction. Additional information is available by contacting PETROCAPITA or its relevant affiliate directly.#205, 120 Country Hills Landing NW Tel: +1.403.218.6506 www.petrocapita.comCalgary, AB T3K 5P3 Fax: +1.403.648.2776Canada